Wooing the Japanese LP

Thomas LaMacchia is an associate in the Tokyo office of law firm White & Case. He can be contacted at tlamacchia@whitecase.com.

Given the low interest rate environment, the vast sums managed by pension funds and other institutional investors, and the comparatively low allocation currently made to alternative investments by Japanese institutional investors, the conditions in Japan seem ideal for fund raising by private equity funds and other alternative asset managers.

To tap this market, foreign fund managers must not only understand the business environment in Japan, but also need to understand the different tax, legal and regulatory issues in Japan and their impact on structuring a fund and drafting the various agreements and other documents required.

As an initial caveat for any non-Japanese fund manager seeking investors (including institutional investors) in Japan, it must be noted that as a general rule only entities properly registered as a securities company or a securities sales intermediary in Japan may solicit investors in Japan. If the fund manger is not so registered in Japan and does not wish to go through the registration procedure, the first step in locating investors in Japan is to work with a registered securities company or securities sales intermediary in Japan.

For managers of non-Japanese investment funds seeking Japanese investors, there are a number of choices to be made with respect to the vehicle through which the investment from Japan will be made. In particular, will the Japanese investors make their investments directly in a fund vehicle together with investors from other jurisdictions? Or will a separate feeder fund be established for Japanese investors and, if so, what type of vehicle (limited partnership, trust, limited liability company, etc.) and where will it be established?

Trusts v. partnerships
Managers of non-Japanese investment funds generally structure investments from Japanese investors as either trusts or limited partnerships. As in all jurisdictions, the choice of structure depends on a variety of factors, such as tax and securities law.

Historically, investment trusts (toushi shintaku) have commonly been used for Japanese domestic investment funds. Doing so allowed an investor to receive advantageous tax treatment, assuming certain requirements were met, in that the trust itself was not taxed and the beneficiaries of the trust were not taxed until distributions or redemption proceeds were received. If such collective investments were made through an investment corporation (toushi houjin), on the other hand, there would be tax at both the corporate level and, upon receipt of distribution or redemption proceeds, at the investor level. Until fairly recently, other domestic entities available in Japan have not been well suited for investment funds in the country.

For the same reason that Japanese domestic trusts are used for collective investment vehicles, foreign trusts are also used for investments by Japanese investors into offshore investment funds. Given the fact, however, that limited partnerships are far more common than trusts in other jurisdictions, such as the United States, non-Japanese limited partnerships are also used for investments by Japanese investors in offshore private equity funds, hedge funds and other alternative investment funds.

Offshore, but not out of bounds
The typical offshore trust structure into which a Japanese investor would invest involves the creation of a trust in an offshore jurisdiction, typically a Cayman Islands or Bermuda unit trust. In order to avoid having the non-Japanese manager be considered the issuer and therefore be the entity required to make the necessary regulatory filings in Japan and be subject to the concomitant legal liability as the issuer, unit trusts are usually formed through a unilateral declaration of trust by a third-party trustee, with the manager simply entering into an investment agreement with the trustee on behalf of the trust.

The trustee is then considered the issuer for Japanese legal purposes, allowing the fund manager to distance itself from any regulatory risk in Japan. Of course, trustees object to this, often strenuously, but using a unilateral declaration of trust has nonetheless developed as the market practice in Japan. Alternatively, a limited partnership can be established either in a tax haven jurisdiction or elsewhere depending on other requirements a fund manager faces. From a Japanese investor's perspective, the main differences between an offshore trust and an offshore limited partnership relate to tax, securities and investment trust law issues in Japan.

If structured correctly, for Japanese tax purposes a foreign investment trust should not result in pass-through tax treatment for Japanese investors. Since the trust was presumably created in a tax haven jurisdiction, such as the Cayman Islands or the Bahamas, there are no taxes on the gain or loss of the trust until proceeds are distributed to the Japanese investors, at which point such distributions are taxed in Japan at ordinary income rates.

For individual investors ordinary income rates can be as high as 50 percent versus 20 percent for capital gains. Corporate investors, on the other hand, pay the same rate for ordinary income and capital gains (maximum rate 42 percent). For individual investors, therefore, the issue is whether the tax deferral is more valuable than the higher rate on ordinary income. For corporate investors, however, the benefit of the tax deferral is not offset by any higher rate on ordinary income.

For hedge funds, which tend to recognize most income or loss during the year, the tax deferral, particularly for corporate investors, can be quite valuable. As a result, most Japanese corporate investors in offshore hedge fund products invest though an offshore unit trust. For private equity funds, which generally distribute proceeds from sales, the tax deferral is less valuable.

As mentioned above, the Japanese tax authorities generally treat limited partnerships as pass-through entities and so no tax deferral is available. For an individual investor, however, the lower capital gains rate would be available for capital gains on investments made by the limited partnership. For a private equity fund, this loss of deferral may not be significant as capital gains proceeds would generally be distributed upon the sale of an investment in any event.

Found in translation
Until September 29, 2007, non-public offers of investment trust interests required the filing of a securities notification, which although much less burdensome than the filing of a securities registration statement for a public offering, was nonetheless a hurdle for many offshore funds. One particular problem is that the offering memorandum and trust deed were required to be translated into Japanese and had to be filed prior to making an offer to potential investors. In addition, for fund managers interested in giving a potential investor the opportunity to negotiate the terms of their investment, having to complete and file an offering memorandum before being presented to the potential investor for feedback and comment sometimes required that a second filing be made with an amended offering memorandum.

On the other hand, non-public offerings of offshore limited partnership did not require the filing of a securities notification. Beginning September 30, 2007, neither the private offering of investment trust interests nor the private offering of limited partnership interests will require the filing of a securities notification.

To offer investment trust interests, or for that matter investment corporation shares, in Japan (whether in a public or non-public offering) a filing with Japan's Financial Services Agency must be made prior to the offering. Offerings of limited partnership interests in Japan, however, do not require a filing with the FSA notwithstanding the obvious similarities between a limited partnership and investment trust. This different treatment for investment trusts and investment limited partnerships was not affected by the recent adoption of the Financial Instruments and Exchange Law in Japan (which significantly revised and restated in a single law the various laws relating to securities and other financial instruments) and therefore such differential treatment will likely continue for the foreseeable future.

The Western influence
Due to the influence of practices in the U.S. and Europe that have developed over the past couple decades, the terms of agreement between investors and managers ? whether structured as limited partnership agreements or trusts ? in the Japanese alternatives investment market are generally similar to those in place elsewhere in the world. For example, compensation for private equity fund managers usually provides for a 2 percent management fee and 20 percent carried interest. Significant variations from this are unusual. Other major provisions ? investment period terms, redemption rights, terms for removal of the manager, etc. ? would be familiar to private equity fund managers elsewhere in the world.

In terms of documentation, perhaps the biggest difference with the rest of the world is its simplicity. This is partly due to different legal regimes (there is no equivalent to ERISA in Japan, nor are the complicated tax allocation provisions necessary, which is good news for those having trouble understanding what ?minimum gain chargeback? is).

It may also be due to the fact that the alternative investment fund industry is relatively new in Japan and therefore document ?bloat? (in which a particular provision once added to an agreement is used in every transaction thereafter because no one feels quite comfortable deleting it) has not yet had had a chance to occur.